1. Copyright © 2012 Pearson Prentice Hall. All rights reserved. Chapter 8 Risk and Return

2. © 2012 Pearson Prentice Hall. All rights reserved. 8-2 Learning Goals LG1Understand the meaning and fundamentals of risk, return, and risk preferences. LG2Describe procedures for assessing and measuring the risk of a single asset. LG3Discuss the measurement of return and standard deviation for a portfolio and the concept of correlation.

3. © 2012 Pearson Prentice Hall. All rights reserved. 8-3 Learning Goals (cont.) LG4Understand the risk and return characteristics of a portfolio in terms of correlation and diversification, and the impact of international assets on a portfolio. LG5Review the two types of risk and the derivation and role of beta in measuring the relevant risk of both a security and a portfolio. LG6Explain the capital asset pricing model (CAPM), its relationship to the security market line (SML), and the major forces causing shifts in the SML.

4. © 2012 Pearson Prentice Hall. All rights reserved. 8-4 Risk and Return Fundamentals In most important business decisions there are two key financial considerations: risk and return. Each financial decision presents certain risk and return characteristics, and the combination of these characteristics can increase or decrease a firm ’ s share price. Analysts use different methods to quantify risk depending on whether they are looking at a single asset or a portfolio — a collection, or group, of assets.

5. © 2012 Pearson Prentice Hall. All rights reserved. 8-5 Risk and Return Fundamentals: Risk Defined Risk is a measure of the uncertainty surrounding the return that an investment will earn or, more formally, the variability of returns associated with a given asset. Return is the total gain or loss experienced on an investment over a given period of time; calculated by dividing the asset ’ s cash distributions during the period, plus change in value, by its beginning-of-period investment value.

6. © 2012 Pearson Prentice Hall. All rights reserved. 8-6 Risk and Return Fundamentals: Risk Defined (cont.) The expression for calculating the total rate of return earned on any asset over period t, r t, is commonly defined as where rtrt = actual, expected, or required rate of return during period t CtCt =cash (flow) received from the asset investment in the time period t – 1 to t PtPt =price (value) of asset at time t Pt –1Pt –1 = price (value) of asset at time t – 1

7. © 2012 Pearson Prentice Hall. All rights reserved. 8-7 Risk and Return Fundamentals: Risk Defined (cont.) At the beginning of the year, Apple stock traded for $90.75 per share, and Wal-Mart was valued at $55.33. During the year, Apple paid no dividends, but Wal-Mart shareholders received dividends of $1.09 per share. At the end of the year, Apple stock was worth $210.73 and Wal-Mart sold for $52.84. We can calculate the annual rate of return, r, for each stock. Apple: ($0 + $210.73 – $90.75) ÷ $90.75 = 132.2% Wal-Mart: ($1.09 + $52.84 – $55.33) ÷ $55.33 = – 2.5%

8. © 2012 Pearson Prentice Hall. All rights reserved. 8-8 Table 8.1 Historical Returns on Selected Investments (1900–2009)

9. © 2012 Pearson Prentice Hall. All rights reserved. 8-9 Risk and Return Fundamentals: Risk Preferences Economists use three categories to describe how investors respond to risk. –Risk averse is the attitude toward risk in which investors would require an increased return as compensation for an increase in risk. –Risk-neutral is the attitude toward risk in which investors choose the investment with the higher return regardless of its risk. –Risk-seeking is the attitude toward risk in which investors prefer investments with greater risk even if they have lower expected returns.

10. © 2012 Pearson Prentice Hall. All rights reserved. 8-10 Risk of a Single Asset: Risk Assessment Scenario analysis is an approach for assessing risk that uses several possible alternative outcomes (scenarios) to obtain a sense of the variability among returns. –One common method involves considering pessimistic (worst), most likely (expected), and optimistic (best) outcomes and the returns associated with them for a given asset. Range is a measure of an asset ’ s risk, which is found by subtracting the return associated with the pessimistic (worst) outcome from the return associated with the optimistic (best) outcome.

11. © 2012 Pearson Prentice Hall. All rights reserved. 8-11 Risk of a Single Asset: Risk Assessment (cont.) Norman Company wants to choose the better of two investments, A and B. Each requires an initial outlay of $10,000 and each has a most likely annual rate of return of 15%. Management has estimated the returns associated with each investment. Asset A appears to be less risky than asset B. The risk averse decision maker would prefer asset A over asset B, because A offers the same most likely return with a lower range (risk).

12. © 2012 Pearson Prentice Hall. All rights reserved. 8-12 Risk of a Single Asset: Risk Assessment Probability is the chance that a given outcome will occur. A probability distribution is a model that relates probabilities to the associated outcomes. A bar chart is the simplest type of probability distribution; shows only a limited number of outcomes and associated probabilities for a given event. A continuous probability distribution is a probability distribution showing all the possible outcomes and associated probabilities for a given event.

13. © 2012 Pearson Prentice Hall. All rights reserved. 8-13 Risk of a Single Asset: Risk Assessment (cont.) Norman Company ’ s past estimates indicate that the probabilities of the pessimistic, most likely, and optimistic outcomes are 25%, 50%, and 25%, respectively. Note that the sum of these probabilities must equal 100%; that is, they must be based on all the alternatives considered.

14. © 2012 Pearson Prentice Hall. All rights reserved. 8-14 Figure 8.1 Bar charts for asset A’s and asset B’s returns

15. © 2012 Pearson Prentice Hall. All rights reserved. 8-15 Figure 8.2 Continuous Probability Distributions

16. © 2012 Pearson Prentice Hall. All rights reserved. 8-16 Risk of a Single Asset: Risk Measurement Standard deviation (  r ) is the most common statistical indicator of an asset ’ s risk; it measures the dispersion around the expected value. Expected value of a return (r) is the average return that an investment is expected to produce over time. where rjrj = return for the j th outcome Pr t =probability of occurrence of the j th outcome n=number of outcomes considered

17. © 2012 Pearson Prentice Hall. All rights reserved. 8-17 Table 8.3 Expected Values of Returns for Assets A and B

18. © 2012 Pearson Prentice Hall. All rights reserved. 8-18 Risk of a Single Asset: Standard Deviation The expression for the standard deviation of returns,  r, is In general, the higher the standard deviation, the greater the risk.

19. © 2012 Pearson Prentice Hall. All rights reserved. 8-19 Table 8.4a The Calculation of the Standard Deviation of the Returns for Assets A and B

20. © 2012 Pearson Prentice Hall. All rights reserved. 8-20 Table 8.4b The Calculation of the Standard Deviation of the Returns for Assets A and B

21. © 2012 Pearson Prentice Hall. All rights reserved. 8-21 Table 8.5 Historical Returns and Standard Deviations on Selected Investments (1900–2009)

22. © 2012 Pearson Prentice Hall. All rights reserved. 8-22 Matter of Fact All Stocks Are Not Created Equal –Stocks are riskier than bonds, but are some stocks riskier than others? –A recent study examined the historical returns of large stocks and small stocks and found that the average annual return on large stocks from 1926-2009 was 11.8%, while small stocks earned 16.7% per year on average. –The higher returns on small stocks came with a cost, however. –The standard deviation of small stock returns was a whopping 32.8%, whereas the standard deviation on large stocks was just 20.5%.

23. © 2012 Pearson Prentice Hall. All rights reserved. 8-23 Figure 8.3 Bell-Shaped Curve

24. © 2012 Pearson Prentice Hall. All rights reserved. 8-24 Risk of a Single Asset: Standard Deviation (cont.) Using the data in Table 8.2 and assuming that the probability distributions of returns for common stocks and bonds are normal, we can surmise that: –68% of the possible outcomes would have a return ranging between 11.1% and 29.7% for stocks and between – 5.2% and 15.2% for bonds –95% of the possible return outcomes would range between – 31.5% and 50.1% for stocks and between – 15.4% and 25.4% for bonds –The greater risk of stocks is clearly reflected in their much wider range of possible returns for each level of confidence (68% or 95%).

25. © 2012 Pearson Prentice Hall. All rights reserved. 8-25 Risk of a Single Asset: Coefficient of Variation The coefficient of variation, CV, is a measure of relative dispersion that is useful in comparing the risks of assets with differing expected returns. A higher coefficient of variation means that an investment has more volatility relative to its expected return.

26. © 2012 Pearson Prentice Hall. All rights reserved. 8-26 Risk of a Single Asset: Coefficient of Variation (cont.) Using the standard deviations (from Table 8.4) and the expected returns (from Table 8.3) for assets A and B to calculate the coefficients of variation yields the following: CV A = 1.41% ÷ 15% = 0.094 CV B = 5.66% ÷ 15% = 0.377

27. © 2012 Pearson Prentice Hall. All rights reserved. 8-27 Personal Finance Example

28. © 2012 Pearson Prentice Hall. All rights reserved. 8-28 Personal Finance Example (cont.) Assuming that the returns are equally probable:

29. © 2012 Pearson Prentice Hall. All rights reserved. 8-29 Risk of a Portfolio In real-world situations, the risk of any single investment would not be viewed independently of other assets. New investments must be considered in light of their impact on the risk and return of an investor ’ s portfolio of assets. The financial manager ’ s goal is to create an efficient portfolio, a portfolio that maximum return for a given level of risk.

30. © 2012 Pearson Prentice Hall. All rights reserved. 8-30 Risk of a Portfolio: Portfolio Return and Standard Deviation The return on a portfolio is a weighted average of the returns on the individual assets from which it is formed. where wjwj = proportion of the portfolio ’ s total dollar value represented by asset j rjrj =return on asset j

31. © 2012 Pearson Prentice Hall. All rights reserved. 8-31 Risk of a Portfolio: Portfolio Return and Standard Deviation James purchases 100 shares of Wal-Mart at a price of $55 per share, so his total investment in Wal-Mart is $5,500. He also buys 100 shares of Cisco Systems at $25 per share, so the total investment in Cisco stock is $2,500. –Combining these two holdings, James ’ total portfolio is worth $8,000. –Of the total, 68.75% is invested in Wal-Mart ($5,500/$8,000) and 31.25% is invested in Cisco Systems ($2,500/$8,000). –Thus, w 1 = 0.6875, w 2 = 0.3125, and w 1 + w 2 = 1.0.

32. © 2012 Pearson Prentice Hall. All rights reserved. 8-32 Table 8.6a Expected Return, Expected Value, and Standard Deviation of Returns for Portfolio XY

33. © 2012 Pearson Prentice Hall. All rights reserved. 8-33 Table 8.6b Expected Return, Expected Value, and Standard Deviation of Returns for Portfolio XY

34. © 2012 Pearson Prentice Hall. All rights reserved. 8-34 Risk of a Portfolio: Correlation Correlation is a statistical measure of the relationship between any two series of numbers. –Positively correlated describes two series that move in the same direction. –Negatively correlated describes two series that move in opposite directions. The correlation coefficient is a measure of the degree of correlation between two series. –Perfectly positively correlated describes two positively correlated series that have a correlation coefficient of +1. –Perfectly negatively correlated describes two negatively correlated series that have a correlation coefficient of – 1.

35. © 2012 Pearson Prentice Hall. All rights reserved. 8-35 Figure 8.4 Correlations

36. © 2012 Pearson Prentice Hall. All rights reserved. 8-36 Risk of a Portfolio: Diversification To reduce overall risk, it is best to diversify by combining, or adding to the portfolio, assets that have the lowest possible correlation. Combining assets that have a low correlation with each other can reduce the overall variability of a portfolio ’ s returns. Uncorrelated describes two series that lack any interaction and therefore have a correlation coefficient close to zero.

37. © 2012 Pearson Prentice Hall. All rights reserved. 8-37 Figure 8.5 Diversification

38. © 2012 Pearson Prentice Hall. All rights reserved. 8-38 Table 8.7 Forecasted Returns, Expected Values, and Standard Deviations for Assets X, Y, and Z and Portfolios XY and XZ

39. © 2012 Pearson Prentice Hall. All rights reserved. 8-39 Risk of a Portfolio: Correlation, Diversification, Risk, and Return Consider two assets — Lo and Hi — with the characteristics described in the table below:

40. © 2012 Pearson Prentice Hall. All rights reserved. 8-40 Figure 8.6 Possible Correlations

41. © 2012 Pearson Prentice Hall. All rights reserved. 8-41 Risk of a Portfolio: International Diversification The inclusion of assets from countries with business cycles that are not highly correlated with the U.S. business cycle reduces the portfolio ’ s responsiveness to market movements. Over long periods, internationally diversified portfolios tend to perform better (meaning that they earn higher returns relative to the risks taken) than purely domestic portfolios. However, over shorter periods such as a year or two, internationally diversified portfolios may perform better or worse than domestic portfolios. Currency risk and political risk are unique to international investing.

42. © 2012 Pearson Prentice Hall. All rights reserved. 8-42 Global Focus An International Flavor to Risk Reduction –Elroy Dimson, Paul Marsh, and Mike Staunton calculated the historical returns on a portfolio that included U.S. stocks as well as stocks from 18 other countries. –This diversified portfolio produced returns that were not quite as high as the U.S. average, just 8.6% per year. –However, the globally diversified portfolio was also less volatile, with an annual standard deviation of 17.8%. –Dividing the standard deviation by the annual return produces a coefficient of variation for the globally diversified portfolio of 2.07, slightly lower than the 2.10 coefficient of variation reported for U.S. stocks in Table 8.5.

43. © 2012 Pearson Prentice Hall. All rights reserved. 8-43 Risk and Return: The Capital Asset Pricing Model (CAPM) The capital asset pricing model (CAPM) is the basic theory that links risk and return for all assets. The CAPM quantifies the relationship between risk and return. In other words, it measures how much additional return an investor should expect from taking a little extra risk.

44. © 2012 Pearson Prentice Hall. All rights reserved. 8-44 Risk and Return: The CAPM: Types of Risk Total risk is the combination of a security ’ s nondiversifiable risk and diversifiable risk. Diversifiable risk is the portion of an asset ’ s risk that is attributable to firm-specific, random causes; can be eliminated through diversification. Also called unsystematic risk. Nondiversifiable risk is the relevant portion of an asset ’ s risk attributable to market factors that affect all firms; cannot be eliminated through diversification. Also called systematic risk. Because any investor can create a portfolio of assets that will eliminate virtually all diversifiable risk, the only relevant risk is nondiversifiable risk.

45. © 2012 Pearson Prentice Hall. All rights reserved. 8-45 Figure 8.7 Risk Reduction

46. © 2012 Pearson Prentice Hall. All rights reserved. 8-46 Risk and Return: The CAPM The beta coefficient (b) is a relative measure of nondiversifiable risk. An index of the degree of movement of an asset ’ s return in response to a change in the market return. –An asset ’ s historical returns are used in finding the asset ’ s beta coefficient. –The beta coefficient for the entire market equals 1.0. All other betas are viewed in relation to this value. The market return is the return on the market portfolio of all traded securities.

47. © 2012 Pearson Prentice Hall. All rights reserved. 8-47 Figure 8.8 Beta Derivation

48. © 2012 Pearson Prentice Hall. All rights reserved. 8-48 Table 8.8 Selected Beta Coefficients and Their Interpretations

49. © 2012 Pearson Prentice Hall. All rights reserved. 8-49 Table 8.9 Beta Coefficients for Selected Stocks (June 7, 2010)

50. © 2012 Pearson Prentice Hall. All rights reserved. 8-50 Risk and Return: The CAPM (cont.) The beta of a portfolio can be estimated by using the betas of the individual assets it includes. Letting w j represent the proportion of the portfolio ’ s total dollar value represented by asset j, and letting b j equal the beta of asset j, we can use the following equation to find the portfolio beta, b p :

51. © 2012 Pearson Prentice Hall. All rights reserved. 8-51 Table 8.10 Mario Austino’s Portfolios V and W

52. © 2012 Pearson Prentice Hall. All rights reserved. 8-52 Risk and Return: The CAPM (cont.) The betas for the two portfolios, b v and b w, can be calculated as follows: bvbv = (0.10  1.65) + (0.30  1.00) + (0.20  1.30) + (0.20  1.10) + (0.20  1.25) =0.165 + 0.300 +0.260 + 0.220 + 0.250 = 1.195 ≈ 1.20 bwbw = (0.10 .80) + (0.10  1.00) + (0.20 .65) + (0.10 .75) + (0.50  1.05) =0.080 + 0.100 + 0.130 +0.075 + 0.525 = 0.91

53. © 2012 Pearson Prentice Hall. All rights reserved. 8-53 Risk and Return: The CAPM (cont.) Using the beta coefficient to measure nondiversifiable risk, the capital asset pricing model (CAPM) is given in the following equation: r j = R F + [b j  (r m – R F )] where rtrt =required return on asset j RFRF =risk-free rate of return, commonly measured by the return on a U.S. Treasury bill bjbj =beta coefficient or index of nondiversifiable risk for asset j rmrm =market return; return on the market portfolio of assets

54. © 2012 Pearson Prentice Hall. All rights reserved. 8-54 Risk and Return: The CAPM (cont.) The CAPM can be divided into two parts: 1.The risk-free rate of return, (R F ) which is the required return on a risk-free asset, typically a 3-month U.S. Treasury bill. 2.The risk premium. The (r m – R F ) portion of the risk premium is called the market risk premium, because it represents the premium the investor must receive for taking the average amount of risk associated with holding the market portfolio of assets.

55. © 2012 Pearson Prentice Hall. All rights reserved. 8-55 Risk and Return: The CAPM (cont.) Historical Risk Premium

56. © 2012 Pearson Prentice Hall. All rights reserved. 8-56 Risk and Return: The CAPM (cont.) Benjamin Corporation, a growing computer software developer, wishes to determine the required return on asset Z, which has a beta of 1.5. The risk-free rate of return is 7%; the return on the market portfolio of assets is 11%. Substituting b Z = 1.5, R F = 7%, and r m = 11% into the CAPM yields a return of: r Z = 7% + [1.5  (11% – 7%)] = 7% + 6% = 13%

57. © 2012 Pearson Prentice Hall. All rights reserved. 8-57 Risk and Return: The CAPM (cont.) The security market line (SML) is the depiction of the capital asset pricing model (CAPM) as a graph that reflects the required return in the marketplace for each level of nondiversifiable risk (beta). It reflects the required return in the marketplace for each level of nondiversifiable risk (beta). In the graph, risk as measured by beta, b, is plotted on the x axis, and required returns, r, are plotted on the y axis.

58. © 2012 Pearson Prentice Hall. All rights reserved. 8-58 Figure 8.9 Security Market Line

59. © 2012 Pearson Prentice Hall. All rights reserved. 8-59 Figure 8.10 Inflation Shifts SML

60. © 2012 Pearson Prentice Hall. All rights reserved. 8-60 Figure 8.11 Risk Aversion Shifts SML

61. © 2012 Pearson Prentice Hall. All rights reserved. 8-61 Risk and Return: The CAPM (cont.) The CAPM relies on historical data which means the betas may or may not actually reflect the future variability of returns. Therefore, the required returns specified by the model should be used only as rough approximations. The CAPM assumes markets are efficient. Although the perfect world of efficient markets appears to be unrealistic, studies have provided support for the existence of the expectational relationship described by the CAPM in active markets such as the NYSE.